Bernanke Prepares to Step Off the Gas: Why Now?

Bernanke Prepares to Step Off the Gas: Why Now?

Ben Bernanke spooked the markets on Wednesday by confirming that the Federal Reserve is getting ready to draw down its policy of pumping tens of billions of dollars into the bond market each month—a strategy known as quantitative easing. After Bernanke spoke, the Dow closed down about two hundred points and interest rates rose slightly as the bond market sold off.

Now, a fall in the stock market of less than 1.5 per cent is nothing to worry about: over the past two years, the Dow has risen by more than twenty-five per cent. But it does raise the question of why Bernanke is choosing this moment to signal that the Fed is getting ready to step off the gas. (That’s his lame metaphor, not mine.) With the sequester still in effect, and likely to be so for the foreseeable future, fiscal policy is acting as a damper on the economy, and G.D.P. growth is still pretty modest—2.4 per cent in the first quarter of 2013 and perhaps as low as two per cent in the second quarter. Moreover, the Fed’s preferred measure of inflation is running at just 1.05 per cent, well below its target of two per cent.

In such circumstances, and with the unemployment rate still above 7.5 per cent, the central bank would normally be expected to provide as much support as possible for the economy. Indeed, some shrewd people on Wall Street expected Bernanke to rein in expectations of an early end to quantitative easing in his press conference today. But he did the opposite, saying that if the economy evolves as the Fed thinks it will, the tapering off of quantitative easing will start later this year, and the program will come to an end by middle of next year.

So why is the Fed getting ready to tighten policy? One argument, a dubious one, is that, actually, it isn’t. In keeping the federal-funds rate at close to zero and continuing to purchase bonds at a reduced rate, the central bank will still have a very expansionary stance. That’s what Bernanke argued on Wednesday. Technically, it’s true, but it ignores the impact of his statements on Wall Street. The way quantitative easing works is by giving a boost to the markets and putting downward pressure on the dollar. Now that investors know the policy is most likely coming to an end next year, they will act upon that news immediately, which could lead to a sharp fall in the stock market and a sizable increase in mortgage rates. And if either of those things happen, the Fed’s forecast of more rapid growth in the second half of this year and the first half of next year could prove to be overoptimistic.

Nobody said that managing the U.S. economy is easy, especially when the mechanism for setting fiscal policy is as dysfunctional as it is these days. The mystery is why Bernanke and his colleagues didn’t wait to see a pickup in growth before announcing their intention to change course, rather than doing it now, when the economic outlook is still pretty uncertain.

One possibility is that they are more confident about the recovery gathering pace than many other people are. In the forecasts they released today, they saw economic growth accelerating to 3.0 to 3.5 per cent next year. But that was only a bit higher than the March projection of 2.9 to 3.4 per cent. Another possibility is that policy makers are more concerned about the return of risk-taking, and the possibility of another bubble emerging, than they are letting on publicly.

The most likely explanation, though, is the simplest one. When the Fed started this latest round of quantitative easing, last September, it was worried about the possibility of another economic downturn. With the housing market recovering more strongly than many experts had expected, and consumer spending holding up pretty well despite the payroll-tax increase that took effect at the beginning of this year, that possibility has receded. To quote the statement that Bernanke and his colleagues put out Wednesday: “The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall.”

From the Fed’s point of view, quantitative easing was always a form of insurance. Now that the likelihood of a disaster has diminished, they don’t think it will be necessary for much longer. But that reasoning depends on the assumption that removing the insurance policy won’t have any significant negative effects. In the coming weeks and months, we will find out if that assumption is warranted.